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The intergovernmental transfer forms the cornerstone of the federalism. In many countries, the fiscal equalization scheme is used for redistributing purposes. Countries such as Canada, Germany, Switzerland, the UK and Australia have applied fiscal equalization formula to transfer fiscal grants to sub‐national governments. Due to the fact that regions differ in their fiscal capacities and fiscal needs, one of the important objectives of the fiscal grant is to reduce the horizontal fiscal imbalances, thus equalizing fiscal gap among regions [1]. This paper studies the problem of how to design fiscal equalization scheme with different fiscal needs dealing with horizontal fiscal imbalances. Under the assumptions made, our results suggest that fiscal needs should not be fully equalized. Instead, in order to reduce fiscal imbalances, the optimal policy should aim at equalizing marginal cost of public funds among regions.
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